Another day, another plan from the US government that has failed to impress the markets. This morning, the Treasury said that they will be injecting capital directly into banks by taking an equity stake. In theory this announcement should give banks the peace of mind to start lending as a direct capital injection from the US government should reduce the risk of counterparty failure. More specifically, Bank A would be less worried about Bank B running out of money to meet their daily obligations which would hopefully make Bank A more willing to lend to Bank B. This was the smartest option announced by the US government to date and the one that leading economists have been calling for. Unfortunately, timing continues to be the Achilles heel of the Bush Administration. The Treasury would not start taking equity stakes until the end of the month while the $700B bailout plan has yet to be up and running. The market wants a fix now and not 3 weeks later. Between now and the end of the month, liquidity could evaporate. We saw that with AIG who quickly ate into their nearly all of their $85B loan from the federal government and are now asking for more money. For the US dollar, this means more weakness against the Japanese Yen as the market waits for the fix that finally works.

The Fix that Finally Works

The question is – what will that fix be? Unfortunately there are little answers to this all important question. Some economists are calling for another round of coordinated rate cuts while others are calling for stimulus checks and direct loans to small businesses. CNBC is even talking about the Fed possibly buying equity futures, but ultimately none of these solutions solve the crisis of confidence in the banking sector. So far, the plans announced by the US government have been reactive, which means that they are in response to the hemorrhaging in the stock market and the widening of credit spreads. What really needs to happen is for banks to just buckle down and start lending. They are in the business of taking risk and it is time that they take on some risk in the interest of unfreezing the credit markets.

G7 Meeting – Most Significant Since 1985 Plaza Accord

The next hope is the G7 meeting. Interestingly enough Treasury Secretary Paulson is calling for an emergency G20 meeting to discuss the financial crisis. The G20 is the 20 largest economies in the world which includes Australia, China, Russia and some countries in the Middle East. This acknowledges the shift in wealth over the past decade and the need to get those countries involved. The G7 meeting is happening on Friday while the G20 meeting is scheduled for the weekend. This will be the most significant G7 / G20 meeting since the 1985 Plaza Accord which marked a major turning point for the US dollar. At that time the 5 nations attending the event agreed to intervene in the currency markets and to sell US dollars to reduce the US current account deficit and to pull the US economy out of a serious recession. FX intervention is still on the table, but it remains to be seen whether even that step will enough to surprise the markets.

How Low Can Stocks Go?

The Dow Jones Industrial Average has fallen to the lowest level in 5 years. Since its peak in October 2007, the Dow has fallen close to 40 percent. The worst financial crisis prior to the current one was the Wall Street Crash of 1929, which led to the Great Depression. Stocks started selling off in October 1929 with the big crash happening on October 29th of that year. Equities did not bottom out until July 1932, after the Dow lost 89 percent of its value.

These are scary figures but it provides a perspective on how bad things have gotten in the past. We sincerely hope that this doesn’t happen, but the lower equities fall, the greater the decline in USD/JPY and carry trades.

Kathy Lien is Director of Currency Research at GFT, and runs KathyLien.com.